The presence of both demand and supply shocks confuses the policy response to Covid-19. With the needs of more than a billion people in question, limited taxpayer resources have to be used effectively. For this, sequencing is important. As supply improved rapidly under Unlock 1 in June, demand seemed the relevant constraint, but in July the spike in new Covid-19 cases and arbitrary lockdowns by States have disrupted supply chains again.

The successes in flattening the curve in Mumbai and Delhi give important lessons States must learn. Gradual unlocking and selective containment, hygiene, distancing and banning large gatherings, work. Shops, offices, industrial establishment and free goods movement must be allowed. Both total unlocking and lockdown must be avoided.

The Reserve Bank of India has undertaken quick innovative responses to the current unprecedented situation — out-of-turn deep rate cuts, pumping in liquidity, moratoria and other regulatory relaxations. What should it do in the next monetary policy meeting? A view often expressed is there are limits to the monetary policy under excess liquidity — the ball has to be passed to the fiscal court. But a strong fiscal response requires monetary support.

Policy reform

Moreover, the Consumer Price Inflation has exceeded RBI’s target band for some months now (6.1 per cent) and the core CPI has also risen. But the Wholesale Price Inflation is negative (-2 per cent). The 2010s’ industrial slowdown was partly due to the RBI targeting a higher CPI when the WPI, which is more relevant for industry, was low. Today, however, nominal policy rates are much lower and inflation figures are unreliable under inherent uncertainties; yet, it is important to continue anchoring inflation expectations and give States time to learn that lockdowns are unproductive. A temporary pause is indicated.

It is also important, however, that the RBI looks through the current consumer inflation spike due to temporary supply disruptions. Inflation expectations may be a bit unhinged now, but thin information gives a large impact to RBI’s communication, which does better over time if it is in line with long-run fundamentals — core inflation — which is expected to be low because of soft demand, commodity prices and wage growth. Headline inflation converges to core under such conditions. The stance should remain accommodative, with space for future cuts clearly indicated.

Meanwhile, the focus should be on reducing spreads and increasing transmission, although it is already happening. Blocked credit lines need to be cleared. The 2010s were a decade of monetary and financial tightening, and need to be reversed.Households and firms have among the lowest leverage in the world. Credit growth has been pro-cyclical and aggravated risks. Policy should aim to make it counter-cyclical.

Counter-cyclical macro and micro prudential regulations can help induce more lending as well as increase financial stability. Banks should be allowed to customise re-structuring for long-term viable firms. Excess durable liquidity, which has clearly improved transmission, should continue; but too much creates dangers, so can be moderated somewhat. The reverse repo rate can be lowered 10 bps to make lending more attractive. Banks have been given a number of carrots, now they need some competition. Lending has increased under the partial credit and MSME warranty, but it is still too slow.

Reforms to build market confidence would reduce spreads. Diversity increases financial stability. It is a good time to implement the Khan Committee recommendation and start corporate repos, so that banks are not the sole source of liquidity to the rest of the financial system and the corporate bond market develops more, hence credit-risk reduces. Smaller NBFCs, which are an important MSME credit channel, may need term loans from some financial institutions since they do not have securities to borrow against.

Fiscal trigger for demand

Since uncertainty and fear restrain private entities, government spending is required to kickstart the economy. But the fiscal deficit has already reached 83 per cent of the Budget target in April-June, because of plunging revenues and frontloading spending. The ex-ante deficit will be greater than the ex-post to the extent that government spending triggers recovery. The Centre needs to make GST transfers to the States, which need to spend on medical infrastructure and supplies, make pending payments to firms (which would be a lifeline for them), restart stalled infrastructure projects, as well as other measures to protect the poor and boost demand. It will need to borrow to spend.

OMOs (open market operations) and surplus liquidity have brought down the 10-year G-Secs’ rate to an 11-year low of 5.8 per cent. There is a large demand for government bonds from banks as well as households who are looking for safe avenues for their rising precautionary savings. G-Secs pay more than the reverse repo rate of 3.35 per cent and banks have booked capital gains from falling rates. Allowing a higher held-to-maturity share can protect them from possible mark-to-market losses if rates rise and increase their demand for G-Secs. More direct platforms could be enabled and advertised for households to buy G-secs.

RBI support

The RBI support through OMOs has helped reduce rates and improve transmission. A clear signal that the RBI will intervene as necessary to keep these rates low can prevent a bad outcome, where markets fear large borrowing cannot be accommodated so that rates do rise.

OMOs are not monetisation. There is a very confused debate on the latter, let’s clarify. Whenever the RBI buys G-Secs or foreign government securities (from the foreign exchange reserves it has acquired) it creates reserve money (also known as durable liquidity or M0) as it pays for them. A surge in foreign inflows needs to be managed since it limits the RBI’s ability to support domestic government borrowing without a rise in its balance sheet.

Fractional banking multiplies this primary source of money supply to create broad money or M3. Banks hold only a fraction of the deposits they receive in liquid assets when making loans. In a modern system supported by a liquidity adjustment facility, broad money growth is endogenous. If the RBI’s balance sheet expands and durable liquidity exceeds banks’ requirements, they will deposit the excess in reverse repo. Since loans create deposits, broad money growth will remain subdued. Therefore, broad money supply growth will not be excessive even if excess reserve money is created.

As long as the reverse repo is less than the average interest rates they pay for deposits, plentiful durable liquidity will only induce banks to lend to earn a higher net interest margin. Spreads will fall, helping a recovery that will allow broad money to rise with nominal income growth. Excess durable liquidity does, however, create risks of arbitrage and asset price rise that regulation has to keep a watchful eye on.

Moreover, OMOs are at the RBI’s discretion and they create a liability for the government that it has to honour. True monetisation only happens if the RBI has to automatically finance a deficit by making a transfer to the government without any rise in government debt. This is neither feasible nor required here, although advocates of such ‘helicopter money’ want advanced-economy central banks to do this to prevent already high public debt rising to unsustainable levels. Indian public debt ratios are minor compared to theirs and we have much better growth prospects to bring down any temporary rise.

The writer is Professor, IGIDR and Member, EAC-PM. Views are personal